Education
Now Reading
Option Basics
35

Option Basics

by The MoleApril 1, 2016

In the context of reintroducing option related strategies here at Evil Speculator I find it important that we establish a baseline of fundamental option related concepts for everyone. Perhaps you’ve never traded options before or maybe you’re just a bit rusty and could use a refresher. So let’s start with the very basics:

What Is An Option And What Does It Do?

A call option offers the holder the right (but not the obligation) to buy an underlying asset at a specified price (the strike price), for a certain period of time. If the underlying fails to meet the strike price before the expiration date, the option expires and becomes worthless. A trader may buy a call option expecting that the price of the underlying instrument will rise, or optionally sell one if anticipating prices will fall.

A put option gives the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. A trader would buy a put option expecting that the price of the underlying instrument will fall, or optionally sell one if anticipating prices will rise.

So basically the stock, index or future that you buy the option for is known as the underlying instrument asset. Options are bought and sold to take advantage of price movements in the underlying. There are several benefits to buying stock or index options for example as opposed to buying the underlying outright. For one options are relatively inexpensive, particularly when compared to the cost of the underlying instrument. Right now today as I’m typing this you or I can buy 100 shares of the Spiders for roughly $206 per share. That means buying 100 shares of SPY will set you back a princely $20,600 plus commission.

Affordability

Instead of doing that you could just buy an option instead and control the same 100 shares for a fraction of the price. The SPY June option trading at-the-money (ATM) at the 206 strike price right now runs about 5.16 points. So by purchasing one single option you spend only $516 plus commission instead of over $25k to control 100 shares of the Spiders. However keep in mind that you are not buying the Spiders, you are merely leasing their profit potential for a given amount of time. And that privilege expires the very same day your option does.

Flexibility

The second reason to buy options is because they are very flexible. By purchasing a put you can easily profit from options even if the stock goes down. And doing that is a lot easier/quicker than borrowing and selling shares in order to establish a short position, which also is a potentially very risky proposition if Yellen for some reason once more surprises the market with even more dovish monetary policies.

Limited Risk

The third advantage to buying an option is that you can never ever lose more than what you paid for that option – period. Your maximum risk exposure is clearly defined and represents the premium you paid when you purchased your option. This does not mean that there is no risk in trading options at all. If you are writing (i.e. selling) naked options then you are in fact assuming unlimited risk, which is why I strongly advice anyone against doing that. For mere mortals like us writing options is tantamount to picking up pennies in front of a steamroller. It works fine for a long time until you accidentally trip one day and watch your account being flattened in mere moments. So leave selling options to the professionals – you’ll sleep a lot better knowing that are not risking your entire account over one open position.

Leverage

The fourth benefit to buying options is that they offer a lot of leverage. Should the Spiders continue to appreciate then my measly $516 could easily multiply by a factor of two or more. But beyond mere profit potential there is a more subtle advantage to option leverage that many retail traders have a hard time grasping – position sizing. On the futures or forex side for instance I rarely devote more than 1% of my account principal to one single position. As a matter of fact we employ risk calculators for both forex and the futures to ensure that our campaign’s stops limit us to as close to the desired R size as possible. The concept of R is explained here and I strongly suggest you understand absorb it before reading on.

Position Sizing

The fifth benefit to trading options is more subtle and one many retail traders are blissfully unaware of. When buying or selling shares of a stock I am facing a liquidity problem. Stock is commonly traded in blocks of 100, so if I want to buy 100 shares of IBM at $50 then I will need to devote $5,000 of my assets for that position. Of course that $5,000 does only theoretically represent my full risk. In my time as a trader I have seen stock shares drop all the way to zero, but outside of 6 sigma events my stop loss is hopefully going to kick in way before that. But the main issue that remains is that of availability of trading assets. I may only have $50k in my account and that means that a full 10% of my assets will now be locked into one single position. That affects my ability to devote funds to other campaigns and also implicitly impairs my ability to diversify across various asset classes or markets.

The Case Against Naked Options

So clearly there are many good reasons for buying an option, however there also some against it. As you already learned options are a wasting assets, which means that from the day you buy one it will slowly lose some of its time value until expiration. Time value is represented by theta – one of the famed option greeks.

An option’s premium is comprised of two components: its intrinsic value and its time value (or extrinsic value). The intrinsic value is the difference between the price of the underlying (for example, the underlying stock or commodity) and the strike price of the option. Any premium that is in excess of the option’s intrinsic value is referred to as its time value.

Now the option’s time value is equal to its premium (i.e. the cost of the option) minus its intrinsic value which is the difference between the strike price and the price of the underlying instrument. I just glanced at the option chains and the Spiders are currently selling for 216.31 which that means my 216 June option I mentioned above at $516 has an intrinsic value of exactly 0.31 points or 31 Dollars! If I deduct that from the full premium of $516 I arrive at $485 and that, as you probably guessed it, is the time (or extrinsic) value of my option. The further price moves above my call’s strike price the higher the option’s intrinsic value and the lower its time value.

As a rough guide – the maximum time value of an option is when it’s trading ATM, above and below its option chain time value gradually decreases each strike. The more time that remains until expiration, the greater the time value of the option.Time value decreases over time, eventually decaying to zero at expiration, a phenomenon known as time decay. This is because traders are willing to pay a higher premium for more time since the contract will have longer to become profitable due to a favorable move in the underlying.

Now loss of time value is the main reason why a significant number of options expire worthless. Here are some recent statistics I lifted off of the CBOE:

  • 10% of option contracts are exercised.
  • 55% – 60% of option contracts are closed out prior to expiration.
  • 30% – 35% of option contracts expire worthless.

Now that’s quite a lot less than some people claim but if you look beneath the numbers you must also recognize the fact that many people buy options not just for speculation but for protection/hedging. If you’re holding 100,000 shares of IBM then buying 1000 puts to ahead of an anticipated volatile move makes complete sense. And that put can easily be sold again a day or two later once markets have quiet down a little again. It will have lost a bit of time value but that’s a small price to pay for downside insurance. [caveat: selling your puts into falling vega (i.e. volatility) may cost you a pretty penny and we’ll be covering that in the future in some detail.]

Some people actually speculate doing the inverse – they may sell 1000 calls against their 100,000 shares which is called writing a covered call. It’s not something I do but investors often use it for generating a bit of extra income. It’s basically a way of locking in your existing profits, but we’ll cover that another time.

Option Strategies

Now the reason why I mentioned the statistics above is that there is another way to trade options which has better much odds but retains our ability to limit our risk. And that, as you may have guessed already, is via the trading option strategies, which involves the simultaneous buying and/or selling of one or more options.

Options strategies not only allow you to profit from bullish or bearish price swings, but they also enable you to profit in sideways tape. One way of doing that is in leveraging volatility – expressed as Vega in our options greeks. Neutral strategies can be further be classified into those which are bullish on volatility and those that are bearish on volatility. Traders can also profit off time decay when the stock market have low volatility as well usually measured by the greek called Theta.

Option strategies is where the real fun begins but in order to use them effectively it is important that we understand them thoroughly in order to anticipate the impact of market moves on our profitability as well as our risk exposure. We will be covering that in much detail in further installments of this series.

So I hope to catch you next time when we’ll dive right into the most basic option strategies, the Bull Call Spread and the Bear Put Spread.


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • Time Bandit

    Speaking of “Naked Options” a friend of mine was holding a few Naked Short Put SPY Contracts on May 6th 2010. A day that will live in infamy. Needless to say, he had his ass handed to him.

    I’ve done a lot of spreads but my favorites were the last two BCS and BPS that you mentioned. The biggest problem that I ran into with more complex spreads such as Condors etc., was when and how to get out of them.

  • http://evilspeculator.com Sir Mole III

    We’ll be sure to cover that, bandit.

  • Tomcat

    Nice refresher!

  • The Options Executioner

    Hey guys, this is Jay, the new options specialist Mole mentioned recently in his “Cooking Up Something New” post. I’m excited to be on board and I hope to have some very interesting dialogue with all of you moving forward. Feel free to drop any questions in these comments and I’ll do my best to answer them.

  • The Options Executioner

    Management of condors is definitely an interesting topic. Lots of different ways to handle it and I’ve seen plenty of good condor traders use various methods successfully. As Mole said, we’ll definitely spend some time on this subject ahead.

  • Time Bandit

    Ridingwaves,

    As we discussed earlier today, price on IXE is still holding on as a short (just barely) by my lens as of 3:38 PM EDT. I’ve put in a MOC order to buy some ERY. But price might increase enough to make me cancel my order before the close so it’ll be down to the wire.

    Ironically my Long in Basic Materials XLB is up while my Short in Crude is up almost $10 per share. :)

  • newbfxtrader

    IXE looks like a good short. Could get to 560’s by end of May.

  • Billabong

    :-))))))))))

  • Time Bandit

    I made a lot of tuition payments to the option market over the years so not all memories are good. :)

  • Ronebadger

    Back to:
    SPX – up 15 pts
    Advancers/Decliners 1488/1609
    What’s wrong with this picture?

  • Billabong

    Nifty Fifty … sorry, I’m having a flash back.

  • http://evilspeculator.com Sir Mole III

    Wow, that really was some April Fool’s Tape.

    .

  • Time Bandit

    Holy Smoly, Nifty 50 goes back 50 years. :)

  • Billabong

    32 point ES move … hammers on YM / ES / NQ. They won’t amount to much unless there’s follow-through on Monday

  • Billabong

    Seems like yesterday … but it was the blow-off phase.

  • Time Bandit

    I feel better that price just sold off enough to still qualify. I really didn’t want to cancel my order yet I must maintain my newly found disipline. So FBOW, ERY filled at $22.99.

  • Time Bandit

    Ain’t that the truth. I feel like time is going by at warp speed.

  • Billabong

    CL closing cents short of the PM session LOD … Let’s see if there’s any follow-through on Monday.

  • Billabong

    Riding Waves observation yesterday on biotech catching a bid was confirmed for me today when BIS failed to hold $42 …. closed it out.

  • Time Bandit

    /CL has a nice looking Daily Candle today. We’ll see what Monday brings. I really don’t want to start “thinking” again but price probably had no fundamental or any kind of reason to get as high as it did other than of course more buyers than sellers.

    I really have no expectations. However, I will allow myself one warm and fuzzy thought for over the weekend and that is the February 11th Low of $26.05. But come Monday morning it’ll be back to reality. :)

  • TheRooster

    Hi Jay, looking forward to seeing what you have to offer. I have personally invested a lot of time in options research and strategies but now dont trade them.

    To be honest i came to the options market with preconceived notions and my research showed that the way to be profitable in the long term was in contravention with my beliefs at the time so i couldnt execute my plans with any consistency.

    I won’t mention yet what i think works because i may still have it wrong! Treating this like a clean slate and looking forward to hearing from someone who has made money in this space.

    Regards

    Roy

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    No Beer?

    Frothy Air coming out of the TVIX foam.
    (2.80, wouldn’t that be a Hoot?)

    I’m outta here.

  • http://greenlander1.blogspot.com/ Greenlander

    CPC ratio clicked today. The last two bearish signals failed but these things often do in strong trends in one direction or the other

  • mugabe

    Quickly jot down your five most important trading principles:
    the rules you will not violate–and cannot violate–in order to be
    successful. Write these down before you proceed with this blog post.

    http://traderfeed.blogspot.com.es/2016/04/what-are-your-trading-principles.html

  • strider

    Welcome to the team Jay

  • rmwaddelljr

    Can you deploy many of the option strategies in an IRA? Short selling isn’t allowed. So selling a put or call could be a problem? Alternative strategies? Thanks

  • The Options Executioner

    The IRA rules always seem to be under review, but at least for now you can do covered calls. Other credit-type strategies I have to double-check what’s currently allowed.

  • The Options Executioner

    Thanks! Looking forward to seeing what we can accomplish.

  • The Options Executioner

    I think one of the keys to successful options trading is being flexible, because entirely different strategies will be useful/worthless depending on market conditions. For instance, the crowd has caught on to the whole volatility-selling thing, but it still can be very profitable (until it’s not). Like anything, strong risk management is key to being a good options trader. That’s something we hope to spend a lot of time on in the coming weeks!

  • rmwaddelljr

    Thanks. At least I’ll have choices on strategies:)

  • Rusty Shank

    I believe most IRA’s allow selling puts. Selling a naked put carries the same risk as outright buying a stock. Your maximum loss occurs if the stock goes to zero. This is VERY different from a naked call, where the maximum loss is unbounded. Selling puts is a valid strategy for buying equities on dips – you’re paid the premium for the put and are assigned the stock. The stock would have dipped anyway if you’d bought it – might as well get paid a little for it!

  • rmwaddelljr

    Thanks Rusty, appreciate it.

  • ricebowl

    I trade options all the time in my IRA. You can buy anything, but the catch is that you can only sell covered calls/puts because the law prohibits IRAs from using margin. A covered call is collateralized by the 100 share block, and a covered put is collateralized by the face value ($strike * 100). In these cases you have defined risk — at most you lose the collateral.

    I mostly buy options rather than write them, but I have sold covered calls a few times. I have never tried to sell covered puts and wouldn’t do it except as a cheap way to buy a stock. Right now a $109 QQQ put expiring in a year requires you to risk $10900 to make at most $875 (~8%). IMO the risk/reward sucks. However, if you were looking to acquire QQQ, it might make sense to sell a put rather than purchase the stock outright; *if* you get exercized, you’d acquire QQQ for $109 – $8.75 = $100.25/share. You also wouldn’t sell a year of theta if you’re trying to get exercized, so realistically this only works if IV is high (i.e. falling underlying).

  • rmwaddelljr

    Thanks for the info & I agree with your explanation.

  • Jimmy Davidson

    Mole what’s your take on roboadvisors? The only one that seems to use hedging is hedgeable but even then I am not sure if they use options, do you know? https://investormint.com/investing/robo-advisors/hedgeable-robo-advisor-review